Black Swans and Other Common-Rare Phenomena

In 2007, Nassim Taleb wrote a ground-breaking book about a common investing fallacy: Banks and trading firms are vulnerable to hazardous and infrequent events and are exposed to loss risk far greater than their usual probability models would predict. Because rare events are very difficult to predict and quantify, most models simply assume that catastrophic losses will never happen. This philosophy works well most of the time, and as a result, many financial planning models work well using traditional risk-return valuations based on standard deviations from expected mean levels.

Unfortunately for the financial market (but luckily for Taleb’s reputation and book sales), the banking crisis and stock market collapse one year after he published the book showed the importance of scenario planning to include rare catastrophes. Taleb’s thesis is not that people should try to predict such rare events — after all, market collapses of that magnitude not due to war have only happened a few times. Rather, strategists should build robustness against potential catastrophic events and prepare to exploit the advantages that might come from an unexpected windfall event.

The recent hurricanes that hit Texas, Florida, and the island territories of Puerto Rico and Virgin Islands got me thinking again about Black Swans. Hurricane Harvey dumped more than 40 inches of rain on Houston, Beaumont, and other Texas Gulf communities, making this storm the most extreme single rain event in the United States. Over 80,000 homes were flooded beyond 18 inches, and almost 800,000 households applied for assistance from FEMA. Shortly after this catastrophe, Puerto Rico and the US and British Virgin Islands all suffered double hurricane damage from Irma and Maria, both Category 5 hurricanes, over a 2 week period. Thankfully, none of the major hurricanes this year resulted in heavy death levels, but the islands will probably be struggling to rebuild their infrastructure and recover their economies for the next several years.

The blockchain world may have just seen its first Black Swan event — ICOs have been banned in two countries where most blockchain innovation has been happening (China and South Korea) and the United States Securities and Exchange Commission has recently been publishing guidelines that suggest a much more restrictive regulatory environment. Several other countries have also announced plans for tighter regulations.

Blockchain innovators are not the first industry segment to receive extraordinary attention from regulators; the US SEC published similar warnings about marijuana “microcap” stocks in 2014, and the recreational alcohol and drug industries remain highly restricted by national and local regulations around the globe. Technologies like radio and nuclear medicine faced similar birthing pains due to safety concerns. However, this is possibly the first time that a new technology has faced such strong financial regulation in so many country markets at once.

How to deal with this challenge? As Taleb suggests, it is not worthwhile to try to predict any specific crisis — they are too rare and too varied. Rather, the best thing for an organization to do is to build up resilience to accommodate the impact from the rare negative event and to seize the opportunity from a rare positive event. Over the past year, hundreds of projects have raised over $2 billion through ICOs. A common current accounting treatment, recognizing the proceeds from ICOs as prepaid revenues against future service deployment, is clearly not a good representation of reality, as it signals that the project could be a Ponzi scheme, especially if there are promises made about the return levels that investors might expect. Another solution would be to craft a new funding mechanism that did not rely on speculation on value for private tokens; there are at least two blockchain tokens that feature fixed value tokens intended to facilitate blockchain transactions without the potential of extraordinary investment returns.

A greater challenge facing the blockchain industry today is the lack of skilled developers. The number of blockchain projects has exploded by about a factor of ten in the past year. While we continue to recruit experienced programmers as best we can, we are also committed to training young programmers to become skilled blockchain coders. That means that we face a modest ramp before the new staff become highly productive, but that makes more sense than waiting for months for rare experienced talent to walk in our doors.

Acknowledgements:

Photo by Gehlert Michael on Unsplash

References:

  1. Taleb, Nassim. The Black Swan: The Impact of the Highly Improbable, 2007. https://en.wikipedia.org/wiki/The_Black_Swan:_The_Impact_of_the_Highly_Improbable . Accessed Oct 5, 2017.
  2. Samenow, Jason, Washington Post. https://www.washingtonpost.com/news/capital-weather-gang/wp/2017/08/29/harvey-marks-the-most-extreme-rain-event-in-u-s-history/?utm_term=.7476e850094e . Accessed Oct 5, 2017.
  3. US Securities and Exchange Commission. https://investor.gov/news-alerts/investor-alerts/investor-alert-marijuana-related-investments . Accessed Oct 5, 2017.
  4. Coindesk ICO Tracker. https://www.coindesk.com/ico-tracker/ . Accessed Oct 5, 2017.